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Federal Reserve Policy

While the threat of a U.S. recession has not abated the Federal Reserve cut the odds that it will be the cause of the next one.

While the threat of a U.S. recession has not abated the Federal Reserve cut the odds that it will be the cause of the next one.

The Fed eased policy at its policy setting meeting last week. Don’t get us wrong, it did not cut interest rates or announce any further asset purchases. Fed policymakers used a tool that central bankers have had in their repertoire for many years but seldom has it been used to the effect that Chairman Janet Yellen did at the March meeting.

Federal Open Market Committee officials dimmed their view of the economy and said they likely won’t raise interest rates as swiftly as they had previously anticipated, a nod to lingering risks posed by soft global growth and financial-market volatility. Policy makers left short-term interest rates steady and said they expect to raise their benchmark rate just twice this year, after an initial increase in December, down from the four they previously predicted. That moves the Fed more into line with the thinking of investors, many of whom doubted the central bank would be able to move as fast as it had forecast.

This wasn’t a shock. Markets had already written off any chance of rates rising that much. But hearing it from the Fed still matters because it proves the central bank means it when it says rate increases aren’t on a preset path. The response in the financial markets said it all: The dollar fell, two-year bond yields dropped, the stock market rose and the price of oil jumped. That represents an easing of financial conditions as important as an actual rate cut. It’s like a big sigh of relief from Mr. Market.

However, the Fed’s revised stance doesn’t eliminate the threat of recession. Rather, by showing a willingness to shift plans as conditions change and new threats arise, the Fed is cutting the odds that its own mistakes will be the cause of the next recession. It’s this cautious stance that has been the most prevalent as it echoes the sentiment of central banks from across the world.

In January, the Bank of Japan cut rates into negative territory. Last month, the People’s Bank of China reduced reserve requirements, freeing banks to lend more. Last week, the European Central Bank cut rates further into negative territory and expanded its bond-buying program.

This is despite the fact that the Fed’s caution doesn’t look justified by either the economy or the markets. Unemployment at 4.9% is around what the Fed considers full employment and consumer prices excluding food and energy rose 2.3% in the year through February, the fastest pace of core inflation in nearly four years.

In addition, the reference to global risks pushes the Fed beyond the domestic policy realm and into the role of the world’s central bank. In this role, the Fed may find itself pressured to be more accommodating than it customarily would be inclined, prone to let inflation in the U.S. surge to offset disinflation in the rest of the world.

Despite a number of risks stemming from heavily indebted emerging markets to a British vote on whether to leave the European Union and a fractious presidential election in the U.S., central banks have little ammunition to deal with the potential shocks to confidence they pose. And with this newly supportive posture, the Fed is trying hard to be part of the solution instead of the problem this time around.

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